Risk Advisory: Forthcoming Changes in the Financial Sector in the Context of Sustainability
A link between finance and sustainable development has recently become one of the major topics for EU regulatory bodies and national governments. Whereas in the past, negotiations primarily centred on financing the political agenda dealing with the so-called Sustainable Development Goals, financial regulatory issues are now increasingly more focused on the sustainability of investments and financial systems in general.
On 24 September, the German Federal Financial Supervisory Authority (BaFin) issued, as one of the first authorities, a consultation document concerning sustainable financing in order to confirm its intention in focusing on sustainability as part of the financial supervision of German banks. The document, which directly affects not only German banks but also their subsidiaries abroad, provided the entities concerned with room for comments until 3 November 2019.
Testing the preparedness of banks
As such, the consultation document is not legally binding; it only specifies the existing regulations at the German and EU levels. However, its significance consists in informing German banks about the priorities of the national regulatory body within the EU-wide evaluation of banking, which is referred to as SREP (Supervisory Review and Evaluation Process – SREP).
Specific sustainability requirements may be divided into four areas:
(1) Reflecting sustainability in business strategies;
(2) Eliminating “risk culture”;
(3) Setting up internal processes for acute risk management; and
(4) Setting up prevention processes for the identification, assessment, management and monitoring of risks arising from climate change.
The evaluation process will also involve stress tests including analyses of scenarios simulating the banks’ preparedness for limited access to fossil fuel and the resulting sudden increase in oil prices. Primarily, banks have to be prepared to answer the following question: Would the key aspects of your business, such as a capital ratio, be endangered if the risks relating to climate change occurred?
Is there an excessive emphasis on sustainability risks?
In the current consumption rate, the global supply of fossil fuels and natural gas will only last until 2069 and 2068, respectively. Since 1980, insurance payments due to extreme weather have increased fivefold, with the related uninsured damage being doubled. Based on research involving the prestigious London School of Economics as one of the research partners, approximately 305 legal proceedings are conducted against banks, insurance companies, investment funds and other institutions that have been accused of having insufficiently reflected climate change in their risk management or of having communicated the climate change risks to their investors and clients in a non-transparent manner.
Pursuant to the “World Economic Landscape 2018” report issued by the World Economic Forum, extreme weather arising from climate change is the most significant risk with potentially the most profound impacts, such as natural disasters, the shortage of drinking water and food, extreme meteorological conditions and cyberattacks. Simultaneously, the likelihood of such events to occur is the greatest in comparison with other types of global risks.
Unified EU taxonomy for sustainable economic activities
The opinion of the German regulatory body BaFin thus reflects the EU-wide and, to a large extent, also the global change in the attitude to the sustainability of finance. In June 2019, a total of 477 global investors holding in the aggregate almost half of the global investment capital sent an appeal addressed to national governments, requesting urgent interventions to mitigate the impacts of climate change. These measures principally include a substantial increase in transparency for large banks and private sector institutions as regards sustainability risks. In the Action plan for financing sustainable growth, Members of the European Parliament approved in September 2019 a Council’s proposal for creating a unified EU taxonomy for sustainable economic activities. The aim of the newly unified taxonomy is to avoid, inter alia, greenwashing by large corporations pretending to have an eco-friendly approach solely for marketing reasons. This change will have an immediate effect on at least 6,000 major private sector players in the EU, including banks.
In its consultation document, BaFin mentions the need for perceiving the sustainability risks not only as risks related to climate change but also as risks related to the societal development and sound governance of public affairs – referred to as Environmental, Social and Corporate governance (ESG). For instance, the lack of transparency will thus be in the spotlight.
Based on an analysis of sustainability risks, BaFin has identified three basic types of risks:
- Risks related to physical changes: floods, droughts and other extreme weather affecting the stability of investments.
- Risks related to a transition to the circular economy: The EU regulations as part of implementing the Action plan towards the circular economy will stimulate changes in national legislation in the next five years, including, for example, limiting plastics or extending producers’ duties. These changes will require a large number of companies to newly set up their business models and customer relationships, which may temporarily decrease revenues.
- Indirect risks: Reputation risks derived from the previous two possibilities.
BaFin already revealed its intention to focus on sustainability as part of the evaluation process several months before at a conference relating to sustainable financing. The on-going clarification of expectations between the national regulator and banking institutions entailed a controversial debate in Germany. However, BaFin along with an international network of non-governmental organisations “Fair Finance Guide” had a key role in Germany when it comes to disseminating information on financial risks arising from climate change. Furthermore, the education of stakeholders in the financial sector was also important in the overall agenda of the governmental regulatory agency. In Germany, Fair Finance Guide has given the best evaluation to smaller banks, such as GLS Bank, Ethik Bank, Tridos Bank and KD Bank. On the other hand, Deutsche Bank or the second largest bank – DZ Bank – received less favourable rating.
Green financing in the Czech Republic?
The issue of sustainable finance emerged in Europe more than 10 years ago for the first time when the first insurance companies started to emphasise the increased frequency and effects of insured events due to climate change. Much greater attention is paid to this agenda in the EU nowadays, especially due to the Action plan for financing sustainable growth and involvement in thematically-oriented international networks of central banks and high governmental representatives.
In the Czech Republic, the so-called green financing is rather restrained. Former Vice-Governor of the Czech National Bank, Mojmír Hampl, opined that sustainable finance is just one of the EU regulations. Despite that, the process of reflecting risk arising from “unsustainable” investments should be underway. However, this process should be risk- rather than politically-oriented and the CNB’s involvement is based on its specific powers in price and financial stability supervision. In the Czech Republic, the most progressive entity in this context is French BNP Paribas, but Dutch ING is also very active. In the future, sustainable financing will predominantly relate to banks having the parent company in Germany, such as Wüstenrot, Commerzbank AG and Deutsche Bank.
Deloitte and support of sustainable finance
Overview of our services
- Complete preparation of banks for SREP (Supervisory Review and Evaluation Process), including stress tests.
- Non-financial reporting in the area of ESG (Environment, Social and Corporate governance). Analysis and setup of preventive processes for the identification, assessment, management and monitoring of risks arising from extreme weather for insurance companies, banks and investments funds.
- Complete documentation for the management of risks arising from climate change and communication with local and EU authorities.